# What is Profitability Ratio? Types, Examples, and Why they Matter?

Are profits always on your mind?
Want to track the KPIs that matter?

In this post, we aim to highlight the significance of the Profitability Ratios and why they are important to your business. Every company follows and monitors a lot of KPIs that are relevant to the business. If profitability ratio hasn’t been on your list of KPIs to be tracked, then this article will assist you in understanding why you must include it.

Here is what the article take you through:

• What Are Profitability Ratios?
• What are the Types of Profitability Ratios
• What are the Most-Commonly Used Profitability Ratios?
• Why are Profitability Ratios Important?
• How to Improve Your Profitability Ratios
• Examples of Profitability Ratios

## What Are Profitability Ratios?

Profitability Ratios are a type of metrics that present an organization’s capabilities to earn profits. These abilities can be assessed from the company’s balance sheets, its sales processes, or its share-holder’s equity. Analysts and investors use profitability ratios to measure and evaluate a company's ability to generate revenue, assets, operating costs, and shareholder equity over time. An organization's profits and value to its shareholders are based on how well its assets are utilized.

Comparing ratios to similar companies or to previous periods is the most effective way to analyze them. Companies typically aim for a higher ratio or value, as this should indicate the business is performing well in terms of revenue, profits, and cash flow. In the next section, we shall learn about the most commonly used profitability ratios observed by companies for analyzing their profitability.

## What are the Types of Profitability Ratios

We have learned so far that the profitability ratios help the companies analyze and monitor the financial health of the business. There are two major categories in which the ratios are divided: Margin Ratios and Return Ratios.

Let’s view the details here:

 Margin Ratio Return Ratios Margin ratios measure the ability of a company to convert sales into profits. An organization's return ratio represents its ability to generate returns for shareholders. Examples under this are gross profit margin, net profit margin, operating profit margin, cash flow margin, EBITDA, EBIT, EBITDAR, operating expense ratio, NOPAT, and overhead ratio. Examples under this are return on assets, cash return on assets, return on equity, return on debt, return on revenue,  return on retained earnings, risk-adjusted return, return on invested capital, and return on capital employed.

## What are the Most-Commonly Used Profitability Ratios?

This section focuses on various profitability ratios that offer insightful information about the well-being of the business. The following are the most-commonly used profitability ratios:

### Gross Profit Margin

Based on the costs needed to produce goods and services, this indicates how much a business is earning. Gross Profit Margin highlights how sales revenue is compared with gross profit. An increase in gross profit margin indicates a more efficient core operation. In other words, it is able to cover operating expenses, fixed costs, dividends, and depreciation, as well as generate net earnings for the business.

A high cost of goods sold indicates a low profit margin. The reason for this may be poor purchasing practices, low selling prices, low sales, competitive markets, or the wrong promotional strategy.

Formula

 Gross Profit Margin= 100 x Net Profit Total Assets

Example

Imagine that you have established a company that sold \$40,000,000 in sports shoes last year with a net profit of \$4,000,000. Calculate the gross margin for the year.

Gross Profit Margin = \$4,000,000 / \$40,000,000 * 100

Gross Profit Margin = 10%

### EBITDA

EBITDA is Earnings Before Interest, Taxes, Depreciation, and Amortization. Basically, it measures the profitability of a company before it deducts non-operating costs such as interest and taxes, and non-cash expenses such as depreciation and amortization.

Comparing a company's EBITDA margin with other companies is straightforward. This is because it does not include volatile or discretionary expenses. However, there is one minor drawback of EBITDA margin. It is that it can differ significantly from net profit and cash flow generation, which provide more accurate measures of performance.

### Net Profit Margin

Net profit margin is the final measure of profitability. In this calculation, the net income of a company is divided by the total revenue. It shows a company's profitability after all expenses, such as interest and taxes, have been deducted. As a measure of profitability, net profit margin takes all factors into consideration.

Formula

 Net Profit Margin= 100 x Net Profit After Tax Net Sales

Example

Imagine, for the previous year, your company has witnessed a net sales  worth \$ 4,000,000 and your Net Profit after tax was \$400,000. So, your calculation for the net profit margin will go as follows:

Net Profit Margin = 100 * 0.1

Net Profit Margin = 10%

Hence, your net profit margin was 10% for the previous year.

### Cash Flow Margin

The cash flow margin measures the relationship between operating income and net sales. Cash flow margin indicates how successful the company is at converting sales into cash. Having a high cash flow percentage means that more money will be available for paying for various expenses like suppliers, utilities, and service debt, as well as to buy capital assets. If, however, a business has a negative cash flow, then it might be losing cash despite its sales or profits. When a company does not have enough cash flow, it borrows or raises capital to stay in business.

### Return on Assets

Return on assets or ROA shows the ratio of a company's net earnings to its total assets. A company's ROA ratio focuses specifically on how much profit it generates after tax on each dollar it invests. Additionally, it measures how asset-intensive the company is. Companies that generate lower profits per dollar of assets are considered to be more asset-intensive.

To generate income, companies with high asset intensities must make significant investments in machines and equipment. Sectors such as telecommunications services and railroads are typically asset-intensive. Companies such as advertising agencies and software companies are less asset-intensive.

Formula

 Return on Assets= 100 x Net Profit Total Assets

Example

You are the CEO of a company that manufactures steel. The total value of your company's assets, such as plant, equipment and machinery, was \$130,000, and your net income was \$20,000. What was your company's return on assets?

Return On Assets = \$20,000 / \$130,000 * 100

ROA = 0.185 * 100

ROA = 15.38%

This means that you generate 15.38 cents of income against every dollar of your company’s assets.

### Return on Equity

Return on equity or the ROE is the ratio of net income to shares owned by investors. Alternatively, it can also be termed as the measure of the return on equity invested by investors.

Stocks of a company that has a high ROE are often cited as a good investment. An organization with a high return on equity will generate more cash internally than an organization with a low return on equity, and will be less dependent on debt financing.

Formula

 Return on Equity = 100 x Profit After Tax Net Worth

Example

Assuming you run a cardboard manufacturing business. Your profit after tax was \$3,000,000 and the net worth of your company is \$19,000,000. How will you calculate the Return on your equity?

 Return on Equity = 100 x 3,000,000 19,000,000
 Return on Equity = 0.157 x100

That implies that the Return on Equity of your company was 15.7%

### Return on Invested Capital

ROIC is a measure of return generated by all capital providers, including investors and bondholders alike. Similar to ROE ratios, this calculation includes the returns from bondholder capital, which makes it a more comprehensive measure.

Formula

To calculate ROIC, the following formula can be used:

 ROIC = EBIT x NOPAT Invested Capital

NOPAT = Net Operating Profit After Tax

OR

NOPAT = EBIT x (1-tax rate)

### Operating Profit

Operating profit margin showcases the cost incurred in the manufacturing of the product that are not directly related to the manufacturing process. It is given by the following formula:

Formula

 Operating Profit = 100 x Operating Profits Net Sales

Example

Let's say you are a manufacturer and seller of computers. You generated gross sales of \$10,000, and your operating revenue was \$100,000. What was your operating margin?

Based on the formula,

Operating Margin = \$10,000 / \$100,000* 100

Operating Margin = 0.10 * 100

Operating Margin = 10%

You spent 10 cents of every dollar you earned in sales on expenses not related to the production of the computers.

## Why are Profitability Ratios Important?

Profitability ratios are important for the following reasons:

### Bring in new Investors

Prior to investing any money in a company, investors always evaluate and assess if the company being invested in is capable of generating sustainable gains for them in the future. Essentially, profitability allows them to know whether or not investing in the said company would be a good idea.

### Assess One’s Financial Standing against their competitors

A self-assessment is always helpful, especially when you are a start-up and need to know where you stand in the current market scenario. So, looking around at the competitors and evaluating your own profitability could help you set goals accordingly for generating better sales and revenue.

### Improve Work areas that need attention

Profitability ratios can present you with data about those areas that need attention within your organization. So, it is a great way to look within the business and improve the structures for a stronger foundation.

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## How to Improve Your Profitability Ratios

Profitability ratios are there to help you with monitoring your performance. In the case where you find the information revealed by these KPIs is not exactly how you want it to be, then here are some steps you can take:

### Cutting down on Inventory

Unused and sitting inventory simply keeps your cash blocked. Look for ways to reduce the stock up and free the cash that has been tied up with it.

### Increasing the Cost

Raise the prices of your goods and services and you will be able to see a visible difference. However, ensure that the process is smooth and you do not harm the number of customers or your customer retention.

### Eliminate the unprofitable services

As a growing business, you must focus only on the business operations that bring in great profits. Therefore, it is essential that you keep away the services and products that haven’t proved any profitable signs.

Keep a close tab of your expenditures. If the expenses list is too high, it will negate the revenue you are generating. Therefore, cut down on your expenses in ways that can be worked out. Try negotiating better with your vendors, contemplate relocation for reducing rental expenditure, free-up and lease out the unused spaces.

### Strategize to find new Clients

Strategizing and expanding your market is one of the finest ways in which you can enhance your profitability ratios. So, boost your sales processes by carefully crafting the strategies to attract new customers and clients.

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## Key Takeaways

The key points from the article are as follows:

• Profitability Ratios are a type of metrics that present an organization’s capabilities to earn profits. These abilities can be assessed from the company’s balance sheets, its sales processes, or its share-holder’s equity.
• Margin Ratios and Return Ratios are the two main categories of profitability ratios.
• Profitability ratios are important as they help bring in more clients and improve the work areas of a company that need attention.
• Cutting down on inventory, increasing the cost of the products, cost-cutting, strategizing to find new clients are some of the ways to improve your profitability ratios.

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